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Buffet2 PDF
Buffet2 PDF
In the 1993 Forbes list of Americas richest people, Warren Main Idea
Buffett had an estimated net worth of $8.3 billion. Of all 69 people Warren Buffets investment methodology is a hybrid mix of the
listed, Buffett is the only one who obtained his wealth from the strategies put forward by two 1930s style investment advisers,
stock market. Ben Graham and Philip Fisher.
Buffett graduated from the University of Nebraska. While there, From Graham, Buffett learned the margin of safety approach -
he read a book The Intelligent Investor by Benjamin Graham. that is, use strict quantative guidelines to buy shares in
This book so impressed Buffett that he went to New York to study companies that are selling for less than their net working capital.
with Ben Graham at the Columbia Graduate Business School. Graham also emphasized that following the short-term
At the age of 25 in 1956, Buffett started an investment fluctuations of the stock market is pointless, and that stock
partnership. He had seven limited partners who contributed positions should be long term.
$105,000 and Buffett as general partner put in $100. The limited From Fisher, Buffett added an appreciation for the effect that
partners received 6-percent interest per year and 75-percent of management can have on the value of any business, and that
the profits generated above this level. Buffett was paid the other diversification increases rather than reduces risk as it becomes
25-percent. Over the next 13 years, this partnership impossible to closely watch all the eggs in too many different
compounded investments at an annual rate of 29.5-percent. In baskets.
1965, Buffett closed the partnership and cashed out with a
personal stake of $25 million. Supporting Ideas
Warren Buffett used his capital to purchase a controlling interest 1. Benjamin Graham
in Berkshire Cotton Manufacturing, a well established but Author of Security Analysis and The Intelligent Investor,
struggling textile company. This company merged with Graham is widely considered as the first professional
Hathaway Manufacturing, and also bought interests in two financial analyst.
insurance companies in 1967. The combined company was Ben Graham grew up in New York and had a science degree
renamed Berkshire Hathaway. from Columbia University. By the age of 25, he was a partner
The insurance companies generated steady cash flow, which in a brokerage firm earning $600,000 per year. He was
was invested in stocks and bonds to have the funds available for financially ruined by the 1929 crash and had to rebuild his
payment of claims. The companys stock portfolio in 1967 was fortune.
$7.2 million, so Buffett assumed control of this. Within two years, Grahams investment philosophy was that a well-chosen,
the stock portfolio had grown to $42 million, and the insurance diversified portfolio of common stocks, based on reasonable
company profits far outweighed the return generated by the prices, were the soundest possible long-term investment
textile side of the company. anyone could make.
During the 1970s, Bershire bought three more insurance To Graham, the distinction between an investment and a
companies and started another five. Buffett also closed the speculation was: An investment operation is one which,
textile side of the company and converted Berkshire Hathaway upon thorough analysis, promises safety of principal and a
into a holding company. Berkshire owns a number of other varied satisfactory return. Operations not meeting those
companies which generate good returns on equity without using requirements are speculative.
debt. By 1993, the noninsurance side of Berkshire-Hathaway
An investment requires safety of principal and a satisfactory
group had a sales turnover of $2.0 billion and earned $176 million
return. Safety is a relative term, and can never be determined
after tax - about 37-percent of the gorups operating earnings.
in an absolute sense. Similarly, the concept of a satisfactory
Warren Buffett and his wife now own around 40-percent of the return (whether dividend income or stock price appreciation)
stock of Berkshire-Hathaway. He works as Chief Executive of is also subjective.
the company for an annual salary of $100,000 per year. Many
Graham described three approaches to investing in common
of his employees who manage different parts of the company
stocks:
earn much more.
1. The Cross-Section Approach.
Berkshire-Hathway had a corporate net worth of $22 million
The investor buys some shares in companies in every sector
when Warren Buffett assumed control. Today, it is worth more
of the market. Then, whatever happens in the economy, at
than $10.2 billion. Buffetts goal is to increase the companys
least one stock will be performing well.
worth by a 15-percent compound rate each year.
2. The Anticipation Approach.
Berkshire pays no dividends but reinvests all money earnt.
a. Short-Term Selectivity.
Therefore, shareholders look to a capital gain in the value of their
This is the investment in companies which have the most
stock. Since 1964, Berkshire shares have grown from $19 each
favourable outlook in the next 6-months to a year. Although
to more than $22,000 per share today. Over the past 25-years,
this is volatile and superficial, this is the dominant approach
Berkshire has grown at an compound rate of 23.2-percent per
used by most sharebrokers.
year - well above Buffetts target of 15-percent per year.
b. Growth Stocks
These are companies whose sales and earnings are
expected to grow at a rate above those of the average
business. The trick is to buy stock in any company whose
products were at an early stage of their life cycle, when profits
and revenues were just about to take off. The difficulty here
is in accurately forecasting rates of growth.
The Warren Buffett Way - Page 3 -
SAMPLE CALCULATION
Assumptions:
1. The companys cash flow will grow at a compound rate of 15% per year consistently for the next 10 years.
2. A discount rate of 9.0% per year is used to allow for the effect of inflation.
3. Assume in year 11 that the companys cash flow will again increase by 5%.
4. All dollar amounts are in millions.
Year 1 2 3 4 5 6 7 8 9 10 TOTAL
Prior Year Cash Flow $275 $316 $363 $417 $480 $552 $635 $730 $840 $966
Growth Rate 15% 15% 15% 15% 15% 15% 15% 15% 15% 15%
Cash Flow $316 $363 $417 $480 $552 $635 $730 $840 $966 $1,111
Discount Factor .9174 .8417 .7722 .7084 .6499 .5963 .5470 .5019 .4604 .4224
Discounted Value Per Annum $290 $306 $322 $340 $359 $379 $399 $422 $445 $469 $3,731
Business Value = Present Value of Future Cash Flows + Present Value of Residual
= $3,731 + $12,324
= $16,055